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Paulson Policy Memorandum
Squaring the Circle:
How China Can Combine Growth with Deleveraging
Tom Orlik and Fielding Chen
March 2016
About the Authors
Tom Orlik
Tom Orlik is Bloomberg’s Chief Asia Economist, based in Beijing. Orlik leads a team
covering China, Japan, India and ASEAN. Previously, he was the chief China economics
correspondent for The Wall Street Journal. Prior to coming to China in 2007, he was an
advisor to the UK Executive Director of the International Monetary Fund and analyst at
the British Treasury. He is the author of Understanding China’s Economic Indicators, a
guide to working with China’s economic data.
Fielding Chen
Fielding Chen is a Bloomberg economist based in Hong Kong. He conducts real time
analysis for China and writes thematic research reports about Northeast Asia for
Bloomberg’s Asia and China Briefs. He was previously a senior economist for Asia at
Banco Bilbao Vizcaya Argentaria. He holds a PhD in economics from Georgia State
University and a Master’s degree in finance from Xiamen University. Chen is a published
author of books on financial risk and the development of China’s Treasury bond market.
He was an instructor at Chinese University of Hong Kong Business School.
Cover Photo: Reuters/Damir Sagolj.
Introduction
C
Second, a step change in transparency
hina pushes into 2016 facing
would enable China’s financial markets
multiple challenges. Supply
to operate more efficiently. By
side reforms and shrinking
channeling more funds to high return
exports threaten to throw growth
private and services sector firms,
and employment off course. A torrid
the Chinese financial system could
expansion of lending has added
generate more output bang for less
to financial risks and raised larger
credit buck.
concerns about the medium-term
growth path. The People’s Bank of
Third, steps that revive faith in China’s
China (PBOC), China’s central bank, has
short- and medium-term growth
stabilized the yuan but the larger goal
prospects,
of a more marketA fiscal stimulus targeted at expanding public
combined
set exchange rate
services and raising the spending power of China’s
with greater
has receded farther
low-income households would provide a boost to
transparency of
into the distance.
growth and employment.
both economic
data and policy
To address these
thinking, would boost confidence,
challenges, this policy memorandum
creating the conditions for the PBOC
proposes action across three fronts:
to move toward a more marketdetermined exchange rate.
First, a fiscal stimulus targeted at
expanding public services and raising
The memo looks at each of these
the spending power of China’s lowmeasures in turn, concluding with
income households would provide a
some more granular recommendations
boost to growth and employment but
that flow from these three arguments.
without the downsides of another
credit-fueled splurge.
1
Properly Deploying Fiscal Stimulus
I
n the past, Chinese monetary policy
has always done the bulk of the work
to support growth. And while this has
been effective, it has come at a cost.
Bank assets have tripled since 2008 and
non-performing loans at 1.3 trillion yuan
($200 billion) are now equal to 2 percent
of China’s GDP.1 Businesses and local
governments in China carry a heavy
burden of debt. Repayment has been
made more difficult as overcapacity has
dented prices and profits.
Even if there were an appetite for a
major monetary stimulus at this point,
the space to do so is limited. Deposit
rates at 1.5 percent mean there is not
much space to cut before banks’ net
interest margins are eroded. A cut in
rates would also open a wider interest
rate differential with the United States
and add to downward pressure on the
yuan, something the PBOC may be keen
to avoid in the immediate future.
This does not, to be sure, mean that
there is no scope for monetary support.
The PBOC is already making stealth
moves to guide market rates lower and
encourage more lending to small and
medium-sized enterprises. It does mean,
however, that more of the heavy lifting
on any stimulus will have to be done
elsewhere.
And that should focus attention squarely
on fiscal policy.
Figure 1. Low Government Debt as % of GDP
2
China’s government debt-to-GDP ratio
is just 43 percent according to the
International Monetary Fund (IMF), low
when compared internationally.2 Even if
that figure does not take account of all
of the Chinese government’s liabilities, a
manageable debt level still means there
is scope to leverage the public sector
balance sheet (see Figure 1).
Indeed, public spending is already
playing an expanded role in bolstering
demand, having accelerated to 20
percent annual growth in the final
quarter of 2015.3 Premier Li Keqiang’s
2016 work report promised to expand
the fiscal deficit to 3 percent of GDP in
2016, up from 2.3 percent in 2015.4 A
fiscal stimulus focused on expanding
social services and raising the spending
power of low-income households would
deliver a significant boost to growth in
the short term. By accelerating gains in
household income, it would also add
impetus to the economic rebalancing
agenda.
The most immediate impact would
come from directly increasing public
spending. In the past, the focus of
fiscal stimulus has been roads, rails,
and power plants. Shifting the focus
by increasing spending on education,
healthcare, and other social services
would deliver a similar boost to growth
but also support robust employment,
raise incomes, and expand the role of
the services sector.
In general, fiscal multipliers should be
larger in countries with multiple market
failures, low debt, and weak private
sector credit demand. China meets
all of these tests and the academic
literature is in broad agreement that
the fiscal multiplier is large. Writing in
2013, for example, Xin Wang and Yi Wen
of Tsinghua University and the Federal
Reserve Bank of St. Louis estimate
that the fiscal multiplier is above 2.5
Wenhui Ye and Dongwei Lou, in a paper
published by a think tank under China’s
Ministry of Finance, estimate that
from 2004 to 2010 it was 1.4.6 An early
attempt to model the impact of China’s
mammoth 2009 stimulus, by Dong He,
Zhiwei Zhang, and Wenlang Zhang put
the multiplier at 1.1.7
Picking a number in the middle of that
range—and this would be conservative,
given that the recent slump in credit
demand should have reduced any drag
from crowding out private investment—
we assume that the fiscal multiplier
is 1.5. That means a 1 percent of GDP
increase in the fiscal deficit would result
in a 1.5 percent expansion in China’s
GDP. If the majority of the expansion
served to increase capacity in public
services, the extra spending could
create up to 10 million new jobs. This
calculation of additional jobs is based
on the breakdown in the share of
additional output between services and
manufacturing and the labor intensity of
output in each of those sectors.
3
There are, of course, shortcomings to
that approach. An increase in capital
spending on schools and hospitals
would have the biggest short-term
positive impact on growth and expand
capacity to provide public services in
the future. But the immediate impact
of extra spending would once again be
channeled into construction.
Still, an increase in spending on nurses
and teachers would not deliver the
same immediate benefit to growth. And
without a supply side response, it would
also risk being lost in higher wages
without improving services. The risk of
a wider inflationary impact is low, given
China’s falling prices and significant slack
in the economy.
Given all these challenges, an alternative
approach is to target deficit spending
toward increasing household incomes.
Cutting income taxes, or replicating
policies employed in the United
Kingdom and elsewhere with negative
tax rates for low earners, would
directly raise household income. The
problem with this approach is that with
household savings rates high, a portion
of the increase in income will be saved,
reducing the stimulus’ bang for the
government’s deficit-spending buck.
Based on average household savings
rates for urban households, the
multiplier for stimulus targeted at
raising household incomes could be
Figure 2. Impact of a Fiscal Stimulus Equivalent to 1% of GDP
4
just 0.7 (see Figure 2). Deficit spending
of 1 percent of GDP would generate
additional output equivalent to 0.7
percent of GDP.8
The effectiveness of a householdincome focused fiscal stimulus could be
enhanced if it was targeted at
low-income households. Contrary to
the popular myth of China’s “thrifty
poor” driving high national saving rates,
it is actually the richest households
that are doing most of the saving.
Low-income households have a higher
propensity to consume. That means a
fiscal stimulus targeted at raising the
income of the bottom 40 percent of
households would likely have a slightly
higher multiplier—about 0.8, based
on National Bureau of Statistics (NBS)
data for urban households (see Figure
3).9 And that data does not include
migrant households, which have an even
lower income and higher propensity to
consume. That means, in turn, that 0.8
is a conservative assumption.
A 1 percent of GDP fiscal stimulus
targeted at raising incomes for the
poorest 40 percent of households would
boost GDP by 0.8 percent, of which
about half would come from additional
service-sector output, creating more
than 4.5 million new jobs.
A hybrid approach of a 0.5 percent
of GDP stimulus to expand public
services and the same amount to raise
Figure 3. Low Income Households Have Lower Saving Rate
5
incomes for low-income households
would have a result in between these
two extremes. GDP would expand 1.1
percent, with most of that coming from
an expanded services sector and as
many as 7 million new jobs created.
In theory, there are reasons for caution
on the effectiveness of any fiscal
stimulus. Ricardian equivalence—
named for the 19th century English
economist David Ricardo—suggests
that if households see higher public
spending today, they will expect it to be
paid for with higher taxes tomorrow. If
they respond with higher savings, then
the impact of the stimulus would be
lessened.
But whether or not that theory holds
in the real world is an issue that
economists hotly debate. China’s recent
history is littered with examples of
short-sighted behavior by households—
most recently, the rush to invest in
China’s bubbly stock market.
Even leaving these concerns aside, and
assuming that China’s households are
rational and forward looking enough to
fit Ricardian theory, there is still reason
to believe a properly targeted fiscal
stimulus could be effective.
The hope would be that a targeted
increase in deficit spending could
catalyze a virtuous circle of rising
incomes, higher demand for services,
job creation, and a further rise in
incomes. A boost to households’
confidence in their future earnings
could offset any concerns about future
increases in taxes.
6
Transparency: Reducing Financial Risks, Facilitating Deleveraging
F
or the last seven years, China’s
credit expansion has outpaced
growth in the real economy,
often by a considerable margin. An
acceleration of lending that started
as a legitimate response to the global
financial crisis has developed its own
momentum.
The consequences, both for China’s
financial system and its real economy,
have been far reaching. Economy-wide
debt rose to about 250 percent of GDP
in 2015, up from 160 percent in 2008
(see Figure 4).10 Assuming an average
10-year maturity on borrowing, and all
loans priced at 5 percent (just above
the benchmark), the cost of repaying
principal and interest is already 37.5
percent of GDP.
On the current trajectory, by 2020
outstanding credit could be 310 percent
of GDP and the cost of debt servicing
will push close to 50 percent of total
output. That, more than anything, lies at
the root of foreign investor angst about
China’s medium-term outlook. After all,
if more and more credit is required to
drive less and less growth, sooner or
later the outcome cannot be good.
And instances of financial stress in China
are on the rise. Bloomberg Intelligence
Economics maintains a database that
captures news reports of defaults by
borrowers in the bond markets, wealthmanagement products that have gone
bad, and other signs of strain (see Figure
5). In 2015, there were 38 reported
cases, ranging from a missed payment
Figure 4. Debt to GDP Level Rising Fast
7
on a 26 million yuan ($4 million) loan
by a Hainan real estate developer to the
case of Fanya Metal Exchange, where
investors protested the freezing of
more than 40 billion yuan ($6.1 billion)
in funds and 16 arrests were made.11
Those 38 cases represent a marked
increase from 12 in 2014, three in 2013,
and just one in 2012. So far in 2016,
Shanshui Cement has missed payment
on a 1.8 billion yuan ($280 million)
bond.12 Ezubo—a peer-to-peer lending
scheme—has allegedly defrauded
investors of close to 50 billion yuan
($7.7 billion), drawing comparisons with
US financial con man Bernie Madoff.13
There is, in one sense, a positive
aspect to the rise of defaults in China’s
financial system: without defaults,
moral hazard abounds, risk is not priced
appropriately, and the financial system
cannot perform its core job of allocating
funds efficiently. But even so, the rise
in instances of financial stress in China
is striking. It speaks to the potential
for more serious problems if credit
continues to expand ahead of the ability
to repay.
Looking at the headline credit data and
reading the steady trickle of negative
stories in the financial press, some
investors have concluded that China is
caught in a debt trap from which it will
be difficult to escape. In our judgment,
that degree of pessimism is a mistake,
for several reasons:
Figure 5. Reported Cases of Financial Stress on the Rise
8
• China’s borrowing is almost entirely
domestic. Foreign borrowing at $856
billion as of the third quarter 2015
accounted for just a few percent of
total outstanding credit. 14 Even if all
foreign lenders pulled out their funds,
the impact on China’s financial system
would be limited. That is a sharp
contrast with the situation faced by
South Korea in the Asian financial crisis
or Greece in the European sovereign
debt crisis, when the exit of foreign
lenders had a catastrophic impact.
• China’s banks have a stable funding
base. For China’s 16 publicly traded
banks—a list that includes giants like
Industrial and Commercial Bank of China
(ICBC), as well as smaller banks like
Shanghai Pudong Development Bank—
deposits account for more than threequarters of liabilities. 15 That stands in
sharp contrast with Lehman Brothers
and the US investment banks that
tottered in 2008. They relied for funds
on the overnight money market, which
meant they were vulnerable to sudden
reversals in confidence.
• On the borrowers’ side, leverage ratios
remain under control. In the industrial
sector as a whole, in the last 10 years,
total liabilities held steady at about
135 percent of owners’ equity. 16 That
suggests, in general, that investments
were productive, generating profits that
have replenished equity.
It also suggests that firms have a
substantial buffer to guard against the
risk of bad loans and bankruptcy.17
Taken together, these factors mean
that there are few immediate triggers
for crisis, so China’s policy makers have
time on their side. But managing down
credit expansion without dealing a
substantial blow to the real economy, or
precipitating the very financial instability
that deleveraging is meant to avoid, will
be a considerable challenge.
The solution has to be multifaceted.
The PBOC has already made important
strides toward the liberalization of
interest rates and the expansion
of direct finance through the bond
market. Aggressively implemented,
the government’s supply side reform
agenda—a priority for 2016—could help
to strip away moral hazard by removing
the implicit no-default guarantee from
state-owned borrowers.
The missing piece of the puzzle, then, is
transparency.
By enabling investors to channel funds
toward high-growth success stories
and away from low-potential “lemons,”
better information can catalyze more
efficient credit allocation.
The wide difference between return on
assets for firms in China’s new and old
economy illustrates the potential for
9
progress if that begins to happen.
The ratio of gross profits to assets for
private firms was about 18 percent in
2014. For state-owned enterprises, it
was 11 percent. The ratio for steel firms
averaged just 7 percent. For production
of automobiles, it was 19 percent.18
This means there is considerable
scope to reduce the credit intensity of
growth—if better information enables
investors to channel more credit to
sectors with higher returns.
In 2016, Premier Li Keqiang is targeting
a 13 percent increase in aggregate
finance, implying some 17.9 trillion yuan
($2.8 trillion) in new lending. China’s
debt to GDP ratio, and the burden of
servicing that debt, is set to rise again.
An increase in the efficiency of lending
would enable a smaller amount of new
credit to do the same amount of work in
supporting growth, helping to bring debt
onto a more sustainable trajectory.
10
Exchange Rate Expectations: Learning How to Float
C
oncern about China’s short- and
medium-term growth prospects
has affected investor sentiment
and complicated PBOC efforts to take
the final steps to liberalize China’s
exchange rate. The central bank moved
in August 2015 to correct the mismatch
between the yuan’s central parity and
spot price, shift focus away from the
yuan-dollar cross and toward the tradeweighted exchange rate, and give the
market greater influence. But these
moves were widely interpreted by
bearish international investors as the
first step in a competitive devaluation.
As a result, the PBOC was forced to
wade back into the market, expending
foreign exchange reserves to prevent a
disorderly drop in the yuan.
China’s policymakers have now
succeeded in stabilizing the currency,
but the larger goal of shifting toward
a more market-set exchange rate—a
critical building block of China’s reform
process—has receded farther into the
distance.
How can China create the conditions for
a shift from the current environment of
exchange rate stress and central bank
intervention to a managed float?
A targeted fiscal stimulus and an
increase in transparency could help
quite a lot. Here are some reasons why:
First, of 15 countries that exited from
pegged exchange rates in the period
Figure 6. Exits from Exchange Rate Pegs Easier When Growth Is Strong
11
since 2000, only those with rising
growth enjoyed a stable currency (see
Figure 6).19 That means that if China
wants to stabilize expectations on
its exchange rate, it needs to restore
confidence in growth. An old fashioned
monetary splurge would boost growth
in the short term. But by adding to the
problem of leverage it would make
China’s longer-term challenges more
difficult to address. As Japan has found
to its cost in the age of “Abenomics,”
major problems on the medium-term
horizon mean that even an aggressive
stimulus can fail to shift fundamental
negative perceptions. A fiscal stimulus
focused on service sectors and lowincome households, by contrast, would
bolster confidence in China’s short- and
long-term prospects.
Second, there is a widespread view
in the markets that China’s GDP data
overstates the actual growth rate. An
informal poll of several economists
conducted by Bloomberg Intelligence
Economics found estimates of the
“true” growth rate in the third quarter
of 2015 ranging from 3.1 to 6.4 percent,
with even the top of the range quite
a bit below the official 6.9 percent
growth rate. Against this backdrop, the
PBOC’s August move was interpreted
by many market participants not as a
technical correction in the yuan fixing
but as confirmation that the markets’
pessimistic views on growth were
correct and the central bank was, quite
simply, beginning a desperate stimulus
attempt.
More granular, high frequency growth
data, with greater transparency on its
methodology, would remove some
of the mistrust in China’s official
numbers, providing a more supportive
atmosphere for the central bank to
manage the delicate transition to a
managed float.
Third, lack of communication by the
PBOC in the period immediately after
the August move was an additional
factor that added to confusion.
Communication improved considerably
in the months that followed. But
there remains a lack of clarity over
key questions, including which basket
of currencies the PBOC references in
setting the exchange rate.
12
Some Recommendations
T
his analysis suggests three broad
areas for action:
Building on the commitment to a more
active fiscal policy at the March 2016
National People’s Congress, China’s
Ministry of Finance should focus an
expanded stimulus on enhancing public
services and raising incomes for low
income households. An aspirational
macroeconomic policy package would
include aggressive supply side reforms
to reduce inefficiency in the state
sector of the economy, an expanded
and targeted fiscal stimulus to offset
the drag on demand from bankruptcies
in traditional industries, and a neutral
monetary policy to avoid exacerbating
stresses from overdone credit.
To build confidence in the official data,
NBS should aim to publish sufficient
granularity of data and transparency
on methodology so that independent
analysts can replicate the official GDP
series. Comprehensive, detailed and
regular reporting on local government
finances would enable a market driven
solution to the problem of provincial
debt.
Corporations, too, should be held
to high reporting standards, with a
presumption in favor of access to
information for investors, analysts, and
the media.
Some of the conditions for shifting
toward a managed float exchange
rate are outside of the control of the
PBOC. But some are not. These include
addressing concerns about credit risks,
data transparency on the financial
system, and communication of policy.
The PBOC should set out a clear plan
for stabilizing the growth of credit,
increase the granularity of data on the
financial system and cross border capital
flows, and establish regular channels for
communication of policy, moving away
from irregular press conferences.
13
Endnotes
Peoples Bank of China, Balance Sheet of Other Depository Corporations, accessed a www.pbc.gov.
cn and China Banking Regulatory Commission, 2015 Major Supervisory Indicators of Commercial
Banking Institutions, accessed at www.cbrc.gov.cn.
1
2
International Monetary Fund, World Economic Outlook, accessed at www.imf.org.
3
Ministry of Finance, 2015 Fiscal Revenue and Expenditure, accessed at www.mof.gov.cn.
4
Li Keqiang, Report on the Work of the Government, accessed at blogs.wsj.com/chinarealtime.
Wang, Xin and Yi Wen, Federal Reserve Bank of St. Louis, “Is Government Spending a Free Lunch? –
Evidence from China”, 2013, https://research.stlouisfed.org/wp/2013/2013-013.pdf.
5
Ye, Wenhui and Dongwei Lou, Chinese Academy of Fiscal Science, “Analysis on the Effectiveness
of China’s Fiscal Stimulus”, 2010, http://www.crifs.org.cn/crifs/html/default/caijingshilun/_
content/10_08/18/1282117310650.html.
6
He, Dong, Zhiwei Zhang, and Wenlang Zhang, Hong Kong Monetary Authority, “How Large Will Be
the Effect of China’s Fiscal Stimulus Package on Output and Employment?”, 2009, http://www.hkma.
gov.hk/media/eng/publication-and-research/research/working-papers/HKMAWP09_05_full.pdf.
7
8
National Bureau of Statistics, China Statistical Yearbook 2015, accessed at www.stats.gov.cn.
9
Bloomberg Intelligence Economics calculations based on People’s Bank of China and National
Bureau of Statistics data, accessed at www.pbc.gov.cn and www.stats.gov.cn.
10
Bloomberg News, “Chinese Investors Protest After $6.7 Billion Frozen, Caixin Says”, accessed at
http://www.bloomberg.com/news/articles/2015-09-22/chinese-investors-protest-after-6-7-billionfrozen-caixin-says.
11
Bloomberg News, “China Shanshui Dispute Intensifies as Unit Files Lawsuit Onshore”
http://www.bloomberg.com/news/articles/2016-01-04/china-shanshui-dispute-intensifies-as-unitfiles-lawsuit-onshore.
12
Bloomberg News, “China Arrests Ezubo Executives in $7.6 Billion P2P Fraud Case”
http://www.bloomberg.com/news/articles/2016-02-01/china-arrests-ezubo-executives-in-7-6-billionp2p-fraud-case.
13
Bank for International Settlements, Consolidated Banking Statistics, accessed at http://www.bis.
org/statistics/b4-cn.pdf.
14
15
Data from banks financial reports, for example Industrial and Commercial Bank of China,
Third Quarterly Report of 2015, accessed at http://v.icbc.com.cn/userfiles/Resources/ICBCLTD/
download/2015/8Third20151030.pdf.
16
Lardy, Nicholas R. Markets over Mao: The Rise of Private Business in China, Peterson Institute for
International Economics, 2014., 2014.
17
18
National Bureau of Statistics, China Statistical Yearbook 2015, accessed at stats.gov.cn.
International Monetary Fund, “Annual Report on Exchange Arrangements and Exchange
Restrictions 2014 and The Evolution of Exchange Rate Regimes Since 1990: Evidence from De Facto
Policies”, accessed at www.imf.org.
19
About Policy Memoranda
Paulson Policy Memoranda are concise, prescriptive essays. Each memorandum is
written by distinguished specialists and addresses one specific public policy challenge of
relevance to the aims of The Paulson Institute.
Policy Memoranda offer background and analysis of a discrete policy challenge but,
most important, offer realistic, concrete, and achievable prescriptions to governments,
businesses, and others who can effect tangible and positive policy change.
The views expressed in Paulson Policy Memoranda are the sole responsibility of the
authors.
About The Paulson Institute
The Paulson Institute, an independent center located at the University of Chicago, is
a non-partisan institution that promotes sustainable economic growth and a cleaner
environment around the world. Established in 2011 by Henry M. Paulson, Jr., former
US Secretary of the Treasury and chairman and chief executive of Goldman Sachs,
the Institute is committed to the principle that today’s most pressing economic and
environmental challenges can be solved only if leading countries work in complementary
ways.
For this reason, the Institute’s initial focus is the United States and China—the world’s
largest economies, energy consumers, and carbon emitters. Major economic and
environmental challenges can be dealt with more efficiently and effectively if the United
States and China work in tandem.
Our Objectives
Specifically, The Paulson Institute fosters international engagement to achieve three
objectives:
• To increase economic activity—including Chinese investment in the United
States—that leads to the creation of jobs.
• To support urban growth, including the promotion of better environmental
policies.
• To encourage responsible executive leadership and best business practices on
issues of international concern.
Our Programs
The Institute’s programs foster engagement among government policymakers, corporate
executives, and leading international experts on economics, business, energy, and the
environment. We are both a think and “do” tank that facilitates the sharing of real-world
experiences and the implementation of practical solutions.
Institute programs and initiatives are focused in five areas: sustainable urbanization,
cross-border investment, climate change and air quality, conservation, and economic
policy research and outreach. The Institute also provides fellowships for students
at the University of Chicago and works with the university to provide a platform for
distinguished thinkers from around the world to convey their ideas.
© The Paulson Institute
All Rights Reserved
The Paulson Institute
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